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Demand Risk and Diversification through Trade

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  • Esposito, Federico
Abstract
I develop a theory of risk diversification through geography. In a general equilibrium trade model with monopolistic competition, characterized by stochastic demand, risk-averse entrepreneurs exploit the spatial correlation of demand across countries to lower the variance of their global sales. I show that the model-consistent measure of demand risk, the “Diversification Index”, depends on the multilateral covariance of a country's demand with all other markets. The model implies that both the probability of entry and the level of trade flows to a market are increasing in the Diversification Index. The firms' risk diversification behavior can generate, upon a trade liberalization, a strong competitive pressure on prices, which in general equilibrium can lead to higher welfare gains from trade than the ones predicted by trade models with risk neutrality. Using a panel of domestic and international sales of Portuguese firms, I estimate “risk-augmented” gravity regressions, which show that the Diversification Index significantly affects trade patterns at the extensive and intensive margins. I quantify that the risk diversification channel increases welfare gains from trade by 16% relative to models with risk neutrality. Finally, the quantitative application highlights the role of demand uncertainty in shaping the economic consequences of the recent integration of China in the global economy.

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  • Esposito, Federico, 2020. "Demand Risk and Diversification through Trade," MPRA Paper 100511, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:100511
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    4. Bianconi, Marcelo & Esposito, Federico & Sammon, Marco, 2021. "Trade policy uncertainty and stock returns," Journal of International Money and Finance, Elsevier, vol. 119(C).
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    11. Ziran Ding, 2022. "Firm heterogeneity, variable markups, and multinational production: A review from trade policy perspective," Journal of Economic Surveys, Wiley Blackwell, vol. 36(5), pages 1311-1357, December.
    12. Emmanuel Dhyne & Ayumu Ken Kikkawa & Magne Mogstad & Felix Tintelnot, 2021. "Trade and Domestic Production Networks," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 88(2), pages 643-668.
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    More about this item

    Keywords

    Demand risk; diversification; welfare gains from trade; international trade;
    All these keywords.

    JEL classification:

    • F1 - International Economics - - Trade
    • F10 - International Economics - - Trade - - - General
    • F15 - International Economics - - Trade - - - Economic Integration

    NEP fields

    This paper has been announced in the following NEP Reports:

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